UK Interest Rates: A dovish hike?

All members agree that any future increases in Bank Rate would be expected to be at a gradual pace and to a limited extent.Bank of England Monetary Policy SummaryNovember 2nd 2017

Given our outlook currently, we anticipate we will need maybe a couple more rate rises, to get inflation back on track…Ben Broadbent, Deputy Governor, Bank of EnglandNovember 3rd 2017

Last time the Bank of England raised interest rates, the pound was one of the strongest currencies in the world, worth more than $2, and almost €1.50. Last week’s decision to raise rates for the first time in over a decade saw a weak pound get even weaker; GBPUSD fell almost two cents on Mark Carney’s announcement, and sterling is now firmly ensconced near the bottom of the G7 currency league table, with only the Japanese Yen more undervalued on a purchasing power parity basis.

Sterling fell despite the rate rise because the markets accepted the Bank of England’s dovish comments (see above) at face value – rates may have gone up, so the conventional wisdom says, but they won’t go up again for a while. A week ago, the interest rate futures market was pricing in a 30% chance that UK rates would hit 1% by the end of next year; this has now been revised down to 20%. By comparison, the futures market is still pricing in a 30% chance the US interest rates will hit 2% next year. The market action last week was basically saying that UK monetary policy is not about to follow the Fed, which has now embarked on a path towards normalization.

Whilst I have some sympathy with this view, I suspect the significance of last week’s change of tack by the Bank of England is underappreciated. UK interest rates have begun to move up (see Chart I) and this is a big deal.

It is notable that Deputy Governor Ben Broadbent came out the day after the interest rate decision, after the markets had conveyed their dovish interpretation of the Bank of England’s message, to insist that this rate hike was likely the start of a trend, rather than a ‘one and done’. The Bank of England does not want to stop here – the normalization of monetary policy is every bit as important in the UK as it is across the Atlantic. No one (except maybe the ECB) wants to be another Japan. In my view, the market is underestimating the Bank of England’s desire to emulate the Fed.

Assuming last week’s interest rate rise is absorbed by the market without too many ill effects (a relatively high probability outcome), the Bank of England will become more confident with respect to further rises. UK economic performance, whilst still somewhat fragile and Brexit-dependant, has recovered from the lows of the summer, and is starting to once again outperform its depressed expectations (see Chart II), labour markets remain relatively healthy and average annual earnings growth has stayed above 2% for the past three years now. Our view is that the probability of two rate hikes next year is closer to 50% than the 20% currently priced in, and this should keep a floor under an already cheap pound.

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